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Cash-Flow Statements Need
To Become More Transparent

By

Art Berkowitz and

Richard Rampell Special to The Wall Street Journal Online

Updated Jan. 13, 2003 6:23 p.m. ET

Cash flow is something we all care about. Without a sense of how much money we have coming and going out every month, making plans for anything -- our housing payments, retirement savings, college tuition, among others -- would be hopelessly complicated and ultimately pointless. Just as individual consumers can and should be aware of where the money comes from and where it goes, companies need to do the same.

But with the recent disclosures by
Tyco
and others about misguided cash-flow reporting, it has become obvious (at least to us) that the current method of disclosing cash flows has failed to meet even minimal levels of clarity. We believe that investors and others interested in financial statements would benefit from changing the format by which cash flows are disclosed.

Here is a simple example of the lack of transparency: If someone sees a number for sales in an income statement, they should be able to look directly at the cash-flow statement to see how much money customers actually paid. How many PCs did
Dell Computer
sell, for instance, and how much money did they take in from those sales? Yet current financial reporting doesn't provide that information. The present format, known as the "indirect method," forces anyone outside the company to make their own estimation.

The information provided is essentially the net-income figure, with "adjustments." These adjustments are items like depreciation and amortization (which don't use cash); increases and decreases of accounts receivable and payable from one period to the next (which indicates that some sales and expenses occurred in one period, but cash was received or paid in another.) But one still can't tell how much cash was actually paid to the company by its customers.

During the public hearings when this method was adopted, there was considerable support for another method known as the "direct method." Those in favor of the direct method pointed to the simplicity of its conceptual basis -- cash in, cash out. The direct method reports gross cash received from customers and the gross cash paid to employees and vendors. It is that simple.

The only requirements are that, at a minimum, the following must broken out as separate line items:

Cash from customers

Interest and dividends received

Other operating cash receipts

Cash paid to employees and vendors

Other operating cash paid such as interest expense, income taxes, etc.

Yet, influential members of the accounting profession prevailed upon the FASB to allow use of the "indirect method" as an alternative. Why? Because it is less work for the accountants. If Tyco had used the "direct method," the method they used to factor out accounts receivable at year end to boost cash balances would have been apparent. It might also have revealed the financial engineering the company was involved in when making acquisitions: Tyco had companies it was acquiring "postpone" recording sales that occurred before the purchase date. The sales would be reported after the acquisition, making it appear that Tyco had actually earned the money after the acquisition. (Of course, it's conceivable Tyco could have used the direct method improperly, too.)

It's probably instructive for a brief aside on the history of how we got the system we have now.

Often, a company will (accurately) report strong earnings, yet show no increase (and sometimes even a decrease) in its cash balances. Or, conversely, the company will report large losses yet still have a muscular bank balance. To explain this enigma, GAAP required the arcanely named statement of changes in financial position be included in a company's annual report (dictated by the old AICPA issued Accounting Principles Board Opinion 19.) Space doesn't permit an explanation of how this statement purported to report cash flows, but suffice it to say that many Wharton MBAs had difficulty understanding it. To the rescue came the Financial Accounting Standards Board with a new requirement that companies include the newly created statement of cash flows. The format of this statement is spelled out in detail in FASB Statement 95, which was issued in 1987 and became effective in 1988.

The FASB guideline permitted the statement of cash flows to be presented using either the "direct" or the "indirect method." However, to quote the rule directly:

"This Statement encourages enterprises to report cash flows from operating activities directly by showing major classes of operating cash receipts and payments (the direct method) [emphasis added]. Enterprises that choose not to show operating cash receipts and payments are required to report the same amount of net cash flow from operating activities indirectly by adjusting net income to reconcile it to net cash flow from operating activities (the indirect or reconciliation method) by removing the effects of (a) all deferrals of past operating cash receipts and payments and all accruals of expected future operating cash receipts and payments and (b) all items that are included in net income that do not affect operating cash receipts and payments. (see a summary of Statement 95)

Notwithstanding the FASB's recommendation, according to the 2003 edition of "Miller GAAP Guide," "the predominant method used in practice is the indirect method." Part of the reason is that the statement required accountants to still prepare a reconciliation of net income to cash flows in a separate schedule, in essence two for the price of one. Even sagacious amateurs find the indirect method difficult to understand. In fact, the indirect method is really just an exhumation of the old statement of changes in financial position corpse. It is easier for (lazy?) accountants to prepare the statement using the indirect method, but investors, particularly unsophisticated ones, would much prefer the direct method. Cash in and cash out is how they think.

The Governmental Accounting Standards Board, in one of its rare instances of being ahead of the private sector, has already adopted the direct method as the only one it will accept. With the accounting profession being in its current state, we can only hope that the Securities and Exchange Commission and the FASB realize that the indirect method is metastasizing and should be cut out.

ABOUT ART BERKOWITZ

Art Berkowitz is a CPA who lives in Southern California. He has been training accountants for over fifteen years in the areas of accounting, investments, and ethics. His new book "Enron: A Professional's Guide to the Events, Ethical Issues, and Proposed Reforms" was published by CCH Incorporated.

ABOUT RICHARD RAMPELL

Richard Rampell, CPA, is the CEO of a full-service accounting firm in South Florida. He is also the chairman of the audit committee of RailAmerica, Inc., a NYSE listed company. He previously worked as the chief financial officer of Burt Reynolds Productions.